Life Insurance Where You Can Take Money Out

Life insurance policies can offer more than a death benefit, serving as a financial resource accessible during the policyholder’s lifetime. Certain types of policies build a cash value component that grows over time. This cash value can be utilized for various financial needs. Understanding how this cash value works and how it can be accessed is important for policyholders.

Types of Policies with Cash Value

Permanent life insurance policies are designed to build cash value over time, distinguishing them from term life insurance. The primary types of permanent policies that accumulate cash value include Whole Life, Universal Life (UL), Indexed Universal Life (IUL), and Variable Universal Life (VUL). Each type has distinct mechanisms for how its cash value grows and how it can be accessed.

Whole life insurance offers guaranteed features, including a guaranteed death benefit and fixed premium payments that remain constant. The cash value grows at a predictable interest rate. Some participating policies may also earn dividends based on the insurer’s performance, which can further increase the cash value or be used in other ways.

Universal Life (UL) insurance offers more flexibility than whole life, allowing policyholders to adjust premium payments and death benefits within certain limits. The cash value in a UL policy grows based on an interest rate set by the insurer, which may adjust periodically but often includes a guaranteed minimum rate. This flexibility can be beneficial for those whose financial situations may change over time.

Indexed Universal Life (IUL) insurance ties the cash value growth to the performance of a specific stock market index, such as the S&P 500, without directly investing in the market. While offering the potential for higher returns during positive market performance, IUL policies typically include a cap on earnings and a guaranteed minimum interest rate, providing some protection against market downturns. This structure allows for growth potential while limiting downside risk.

Variable Universal Life (VUL) insurance offers the most investment control, allowing policyholders to allocate the cash value portion into various sub-accounts, similar to mutual funds. The growth of the cash value in a VUL policy depends directly on the performance of these underlying investments, meaning there is potential for significant gains but also greater risk, including the possibility of losing money. This type of policy suits individuals with a higher risk tolerance who prefer to manage their investments actively.

How Cash Value Accumulates

Cash value accumulation within permanent life insurance policies is a fundamental aspect of their design. When a policyholder pays premiums, a portion goes towards the cost of insurance, covering the death benefit and administrative fees. The remaining amount is allocated to the policy’s cash value component, allowing it to grow over time.

The growth of cash value is influenced by several factors, including the policy type and its terms. Whole life policies often have a guaranteed interest rate that steadily increases the cash value. Universal life policies may have an interest rate that adjusts over time, usually with a minimum guaranteed rate.

In indexed universal life policies, cash value growth is linked to a market index, crediting interest based on that index’s performance, subject to caps and floors. Variable universal life policies allow the cash value to fluctuate directly with the performance of chosen investment sub-accounts. A significant advantage of cash value growth is its tax-deferred nature, meaning earnings are not taxed as they accumulate within the policy. This deferral allows the cash value to compound more efficiently over many years.

Methods for Accessing Cash Value

Policyholders have several ways to access the accumulated cash value within their permanent life insurance policies. The two primary methods are taking policy loans and making withdrawals.

Policy loans allow the policyholder to borrow money from the insurer, using the policy’s cash value as collateral. This means the cash value itself is not directly removed, but rather serves as security for a loan from the insurance company. Policy loans typically do not require a credit check or a lengthy approval process, as the policy’s cash value guarantees the loan. Insurers generally allow borrowing up to a certain percentage of the cash value, often around 90%.

Withdrawals, conversely, involve directly removing a portion of the cash value from the policy. When a withdrawal is made, the cash value in the policy is reduced by the amount withdrawn. Unlike loans, withdrawals do not typically accrue interest, as they are a direct reduction of the policy’s accumulated funds.

Consequences of Accessing Cash Value

Accessing the cash value of a life insurance policy carries various financial implications that policyholders should consider. A direct consequence of both policy loans and withdrawals is a potential reduction in the policy’s death benefit. If a policy loan is not repaid, the outstanding loan balance, including any accrued interest, will be subtracted from the death benefit paid to beneficiaries upon the insured’s death. Similarly, withdrawals permanently reduce the cash value and, by extension, the death benefit, as the removed funds are no longer part of the policy’s value.

Policy loans accrue interest, which can be fixed or variable depending on the policy terms. While policyholders are not always obligated to repay the loan, the accumulating interest can significantly increase the outstanding balance. If the loan balance, including interest, grows to exceed the policy’s cash value, the policy could lapse, leading to a loss of coverage. Such a lapse can have severe repercussions, including potential tax consequences.

Regarding tax implications, policy loans are generally not considered taxable income as long as the policy remains in force, because they are treated as a debt against the policy’s value. However, if the policy lapses or is surrendered with an outstanding loan, the unpaid loan amount, to the extent it exceeds the policyholder’s basis (premiums paid), may become taxable income.

Withdrawals are typically tax-free up to the policyholder’s basis in the policy, which is generally the total amount of premiums paid minus any previous withdrawals or dividends received. Any amount withdrawn that exceeds this basis, representing the policy’s earnings, is usually considered taxable income and may be subject to ordinary income tax rates. For policies classified as Modified Endowment Contracts (MECs), different tax rules apply; loans and withdrawals from MECs are generally taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are considered withdrawn first and are immediately taxable, potentially incurring an additional 10% penalty if the policyholder is under age 59½.